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Market instability looms on horizon

To celebrate our 25th wedding anniversary in 1998, my wife and I attended a pension industry conference at the Del Coronado Hotel in San Diego.

It was really great. We listened to a speech by economist David Smith, who predicted that the market was grossly overheated and that a crash was in the offing.

The audience, made up of pension professionals, was openly hostile. Most of us had benefited from the terrific run-up in mutual fund values during the '90s and we just didn't want to hear that it all might end. We wanted to believe in the changing "paradigm," so we were asking ourselves, "Who is this guy and why doesn't he 'get it'?"

Well, my prescient new best friend is back, and this time I'm happy to hear from him.

Economists are not immune to the pressures that their employers bring to bear. I'm finding that, in retrospect, the quality of economic advice seems to rise with the level of the economists' independence.

Here's an example: The New York Times on Tuesday had a lineup of five economists predicting what we might expect in 2006. Four of the five economists were from the brokerage industry and were all painting a guardedly rosy picture.

It is clear that they are influenced in part by their need to inspire confidence in the markets and serve the interests of the armies of brokers they support. Their insight centered on what each selected as a few strong sectors of the market, and they all predicted flat or a slight rise in overall values for 2006.

The fifth economist was from Knight Capital Group, which is a trading service for the online brokerage business. They make money regardless of how the market is doing, so their economist stepped right up to the plate and predicted a 20 percent to 25 percent decline in the second half of 2006. He went so far as to say that this major decline would be a great opportunity to buy heavily into technology because this sector has lagged the other portions of the market.

In Smith's Dec. 18 newsletter, he ticks off a list of unsustainable conditions: a huge trade deficit, growing debt held by foreigners, U.S. consumers spending more than we earn, historically low mortgage rates destined to rise and housing prices continuing to rise faster than incomes.

A sudden weakening in any one of these areas could turn the rest into the perfect storm. As early as last April, Paul Volker wrote an article for the Washington Post entitled "Economy on Thin Ice." This former Fed Chairman is now as independent as anyone can get, and he described the circumstances as "(more) dangerous and intractable as any I can remember."

Paul Krugman, an independent economist who teaches at Princeton, wrote a column outlining the two halves of the housing market and pointing out that recently published national statistics don't tell the story:

We have housing prices in the Midwestern flatlands where land is cheap. Cost-effective urban sprawl keeps housing costs low. Meanwhile, on the two coasts, there is nothing but expensive land available for growth, so this is where prices on existing homes have escalated dramatically. With most of the U.S. property value on the two coasts, the statistics about average home price changes nationally can lead to flawed thinking.

Krugman argues that anyone who can't recognize a bubble when they see it needs to have his head examined.

If this weren't enough, we have an inverted yield curve where short-term interest rates are higher than long-term rates. In all but two of the last 40 times this condition has persisted, we have had a major decline in the stock market and a recession that followed. This would mean that the current inversion offers a 5 percent possibility that everything will roll along just fine in 2006.

For those of us managing our retirement nest eggs, we should be taking some of this bad news into consideration as we (hopefully) take the time to rebalance our assets for the coming year.

That does not mean abandoning stock funds, but it does mean a shift to more stable, value-oriented funds. Our winners in recent years have included small cap funds, REITs and foreign funds.

It may be time to sell portions of our winners and consider adding to the venerable S&P 500 index funds and other large-cap funds that pay dividends and offer more solid footing during market downturns.

Regardless of what the market does, keep the long view in mind and resist the urge to try to time what could be the coming downturn. From the time of David Smith's speech in 1998 until the top of the market in 2001, the market rose over 50 percent and tech funds more than doubled.

Even the economists I have come to respect don't always get it right, so we needn't get discouraged if we lose a little money from time to time.

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